Debunking active management myths – Part 1

Active versus Passive

With $504 billion flowing into passively managed products and $316 billion fleeing actively managed mutual funds in 2016 in the U.S.1, the active-versus-passive debate appears to be tipping in favor of passive management. To be clear, at Russell Investments we believe the binary choice between active or passive is a false one. Resist it. Active AND passive investing are both credible strategies within a multi-asset portfolio.

To help separate myth from truth in this debate, we will publish a series of blog posts over the course of the next few weeks:

  • Myth #1: Active management can’t add value after taking fees into account.
  • Myth #2: U.S. large-cap ETFs are proof that passive beats active.

Today, we begin by discussing the first myth: “Active management can’t add value after taking fees into account.”

The reality

We believe there are active managers in every asset class who possess the skill to outperform the market, net of their management fees. Note, the operative word in the previous sentence is “skill.” Beating the benchmark with active management requires finding superior active managers. Average managers don’t cut it.

The basis for our belief

Passive investing attempts to replicate the market and generate performance in line with a broad cap-weighted market index over a full market cycle. But, what exactly is that “market” that a passive investing approach tries to replicate? That market is in fact the sum of all the investment decisions made by active managers. In a sense, a market index’s performance, over a full market cycle, represents the average performance of all those active managers.

As a result, when it comes to after-fee performance, the theoretical average active manager (delivering average performance) underperforms the market by the exact amount of their fee. But this is only true for the average manager. Below average managers would underperform by more.

The theoretical average passive strategy’s after-fee performance would also fall short of the market index. That shortfall would be exactly equal to the amount of their fee. But because the fee of passive products is typically lower than that of actively-managed products, the average passive manager tends to outperform the average active manager by the difference of their respective fees. But let’s be clear: The passive solution is essentially guaranteed to underperform the market after management fees.

What about skilled active managers – those who beat the benchmark?

There is a tremendous range of performance among active managers. Depending on the asset class and period considered, the return spread can be as large as 61%.2 At Russell Investments, we believe there are active managers in every asset class that possess the skill to outperform the market over a full market cycle – and we believe that skill can be identified in advance. This belief is the basis for the industry of manager research – a skillset we helped pioneer nearly fifty years ago and still invest heavily in today for this very purpose. In fact, some of the largest, most demanding investors in the world – many of whom are our consulting clients – rely on manager researchers like Russell Investments to identify outperforming active managers.

Some important factors for investors to bear in mind:

  • Skill matters.
    For investors seeking to capture the extra return potential that active management attempts to deliver, we believe it is important to work with a credible provider of manager research capable of identifying and combining skilled active management.
  • Time matters.
    The market moves in cycles and even skilled active managers may underperform at times within a cycle. We believe you should pack your patience and keep the faith – give it time to pay off.

The bottom line

The fact is, investing of any sort is inherently risky. And we agree that the average active manager doesn’t add value after fees. To give investors the highest likelihood of beating the benchmark, you need to find outperforming managers. And then you need to give your strategy time to pay off.

And sure, the low-fee structure of passive investing has obvious appeal. But in recent years, many investors have assumed that active management can’t add value after fees. This assumption is, in part, because the fervor around passive investing has created its own mythology. Some follow the passive trend without question. Others choose to make data-driven decisions. If you’re a decision maker, we encourage you to take an objective look at the real-world application of active and passive.

Disclosures:

1 Source: Morningstar. Passive products include long-term and sector mutual funds and ETFs. Excludes leveraged long/short products, money market funds and fund of funds. Active management includes all mutual funds, except money market funds and fund of funds.

2 Based on Morningstar Large Cap Blend category cumulative return for the five years ending 12/31/2016. The worst fund’s performance was 23% vs the best fund’s performance of 84%.

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

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Copyright © Russell Investments Group, LLC 2017. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

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